The Taiwan Banker

The Taiwan Banker

RMB Internalization May be a Fruitless Endeavor

RMB

2022.05 The Taiwan Banker NO.149 / By Edward Hsieh

RMB Internalization May be a Fruitless EndeavorBanker's Digest
In the past, with its sound legal system, simple and low tax system, free movement of funds, abundant financial products, and large talent pool, Hong Kong secured its position as an international financial center, as well as the headquarters location of many financial institutions in Asia. With its unique advantage of linkage to China, it became an information and capital conduit for foreign investors into China. After China's reform and opening up, Hong Kong became the most ideal place to capture China's business opportunities, as well as the world’s largest offshore RMB trading center.Reform and Opening led to Hong Kong’s offshore RMB market To promote the internationalization of the RMB, the mainland Chinese government made full use of Hong Kong’s advantages to vigorously develop its offshore RMB trading business.Hong Kong’s main offshore RMB businesses include Qualified Foreign Institutional Investor (QFII), RMB Qualified Foreign Institutional Investor (RQFII), the Shanghai-Shenzhen-Hong Kong Stock Connect, and mutual recognition of funds and Bond Connect through the continuous development of financial channels between Hong Kong and China through policy arrangements (Figure 1).Of course, China's rapid economic growth over the past few years, coupled with expected RMB appreciation, are important keys to the internationalization of the RMB.Regarding Hong Kong's role in RMB internationalization, its efficient and stable financial infrastructure, large capital pool, and multiple cross-border capital circulation channels have indeed made it the largest and most important offshore RMB market in the world, providing comprehensive RMB-denominated financial services including clearing, settlement, financing, asset management, and risk management. Hong Kong's offshore RMB advantages and achievements are shown in Table 1.In November 2020, the People's Bank of China and Hong Kong Monetary Authority renewed their currency swap agreement, expanding its scale from RMB 400 billion/HKD 470 billion to RMB 500 billion/HKD 590 billion with a validity period of 5 years. This exchange of local trade and investment will continue to promote Hong Kong’s offshore RMB market development.In addition, Yi Gang, Governor of the People's Bank of China, said in December 2021, “Hong Kong accounts for nearly 50% of cross-border RMB payments, nearly 60% of offshore RMB deposits, and more than 80% of offshore RMB bond issuance.”The expansion of the agreement renewal and the content of Yi Gang's conversation help explain Hong Kong's important role in the offshore RMB market.A comprehensive discussion of the RMB internationalization process can be observed from three aspects. As a medium of exchange, international currencies must be used for transaction settlement. China has agreed with ASEAN and other neighboring countries to use RMB for trade settlement. Statistics from the People's Bank of China show that in 2020, RMB settlement accounted for 18.44% of China’s total imports and exports. According to data released by the Society for Worldwide Interbank Financial Telecommunication (SWIFT), in January 2022, RMB payment ranked 4th in the world for global payment, accounting for 3.2%, up from 2.7% in December 2022.As a unit of price, some international commodity transactions related to China have been priced in RMB, while RMB-denominated bonds and related financial products may be issued in Hong Kong and elsewhere.Finally, as a store of value, money is mainly used for investment and must have the function of a reserve currency. In 2016, the RMB joined the International Monetary Fund's Special Drawing Rights (SDR), and the proportion of RMB foreign exchange reserves held by various central banks has gradually increased.CNY and CNH – “one currency, two markets” At first glance, the offshore RMB market and RMB internationalization in Hong Kong seem to be developing smoothly. Looking forward to the future, however, it is clear that RMB internationalization will face some serious problems. According to the “impossible trinity” of international finance theory, free movement of capital, exchange rate stability, and monetary policy autonomy cannot be achieved at the same time. Most countries choose the free movement of capital and an independent monetary policy at the expense of a stable exchange rate. The free movement of capital is regarded as the only way for a currency to become an international currency.Looking at China's past economic and financial development, it has chosen the latter two. Of course, monetary policy autonomy is essential, but a relatively stable exchange rate is also very important in order to ensure the driving force of the export trade pillar of the economy.Therefore, the free movement of capital is often sacrificed, and the RMB capital account is strictly regulated.However, internationalization of the RMB has great political and economic significance for China. Therefore, Hong Kong, which has developed financial infrastructure, trust by Western capital, and relatively free capital movement, has played a key role in the RMB internationalization process. In order to achieve the two goals of stabilizing the exchange rate and promoting RMB internationalization, the Chinese government has cleverly adapted Deng Xiaoping’s “one country, two systems” policy as a “One Currency, Two Markets” strategy for the RMB, creating a new CNH market in addition to the CNY, using Hong Kong to establish an offshore market with BOCHK as the RMB clearing bank, setting up a “firewall” between the two markets. The CNH is fully convertible in the offshore market, while CNY is partially convertible in the onshore market. Based on this arrangement, Hong Kong's offshore RMB market plays a unique dual role, not only serving as an exchange and exchange channel for overseas funds, but also as a firewall for financial stability in China. Specifically, the central government has cooperated with the Hong Kong Special Administrative Region to establish investment channels such as Shanghai-Shenzhen-Hong Kong Stock Connect, Bond Connect, QDII, QFII, and Cross-border Wealth Management Connect to test the opening of onshore capital accounts.Fundamental problems of reform remain unsolvedHong Kong's offshore RMB market allows China to help internationalize its currency without fully opening its capital account.At the same time, the Hong Kong offshore market also enables foreign holders of RMB-denominated assets to separate currency risk from country risk.Considering China’s special circumstances, the offshore market is crucial to internationalization of the RMB.It is however only a transitional step, not the ultimate driving force for RMB internationalization.Ultimately, China will still need to open up its onshore capital account and reform its financial market in order for the RMB to meet the functional definition of an international currency, so that the world will be willing to accept and hold the RMB.This is also related to China’s GDP and trade, global confidence in China's political and economic system, and expectations for RMB appreciation.Looking at the recent situation, since 2018, the trade war, protests in Hong Kong and the national security legislation which followed, and the coronavirus pandemic have changed the previous economic and financial order. Trade-related current account cash flows have been changed through adjustment of the global supply chain, and capital account flows have shifted due to changing investment preferences.In an age when expectation of stability is paramount, Hong Kong seems to be a core task for China when it comes to acting as an international financial center or promoting internationalization of the RMB.Taking Hong Kong’s offshore central bank bills as an example, the People’s Bank of China has issued central bank bills in Hong Kong since November 2018. Its official explanation is to enrich offshore RMB products, enhance the functionality of Hong Kong’s RMB market, and meet the demands for a large number of high-quality and highly liquid RMB assets in overseas markets.However, we can also observe an interesting phenomenon from several issuance records. The announcement date is usually accompanied by appreciation of the offshore RMB (CNH) against the US dollar. In other words, the issuance of PBOC offshore central banknotes has the function of helping stabilize the exchange rate during RMB depreciation.The vigorous development of Hong Kong as an international financial center over the past 20 years was indeed related to the vast opportunity for China's economic growth and offshore RMB trading business, but recent years have shaken the trust of international capital in Hong Kong. The exodus of financial industry practitioners at all levels may also be a signal.These changes have also filled Hong Kong with mainlanders doing business in RMB. Such developments are not due to market supply and demand, but more due to the political needs of the mainland government, who wants Hong Kong to act as a firewall between it and the outside world.Can Hong Kong continue to play its international financial role familiar to Western capital to promote RMB internationalization as China's rapid growth ceases and its status as the world’s factory is shaken, and Western financial institutions and people continue their exodus? One thing is clear: Hong Kong is not what it once was.The author of this article is Deputy Director of the Communication and Publication Center of TABF